Paying for College: Savings Plan vs. Prepayment

As college costs continue to soar, families across America are confronting a financial burden they find difficult if not impossible to manage alone. Throughout the last decade, college tuitions have risen faster than the rate of inflation. At the same time, our tax system and the lack of good investment opportunities have served as disincentives for parents to save--which has further compounded the problem.

Existing programs like student loans are unable to address a problem of this scope. Nor are recently proposed college tuition savings plans (which call for state or federal subsidies) likely to suffice.

The search for a method to encourage savings for college without drawing on limited public resources has led to a new investment idea, prepayment of tuition. Prepayment has the potential to increase families college savings without state or federal subsidies and to simultaneously provide financial benefits to colleges and universities.

Nearly every state legislature has discussed college savings or prepayment plans and several have plans in place. An even greater number of individual college plans and commercial plans have already appeared.

Although difficult to implement, prepayment plans have the potential to totally restructure higher education finance in the decades ahead.

In order to make clear the importance and potential of prepayment plans, the principal advantages and disadvantages of state, national, and commercial savings plans will first be quickly reviewed, followed by a comparison with state and national prepayment plans.

State Savings Plans

After Michigan announced its plan to permit families to prepay for higher education, a flood of new proposals followed. Many states have simply copied the Michigan legislation, changing only the state name and relevant statute numbers. A number of states, however, rejected the prepayment concept and attempted to introduce a state-based savings plan. Illinois is using tax-exempt bonds. New York is working on a savings plan with "up front" subsidies for potential low-income savers. Kentucky is trying to create tax advantages using an "endowment."

State savings plans are invariably tied to future attendance at one of the state institutions. To the extent that state lawmakers are unwilling to assist families who believe that out-of-state attendance is their best option, state programs will remain seriously flawed. A single investment approach with state imprimatur avoids complexity but is a disservice to the state's citizens.

National Savings Plans

A national plan is one way of overcoming the problem of restrictions on out-of-state use in state plans. One of the new savings programs that have been proposed at the national level would employ U.S. Savings Bonds, which are sold at a deep discount and feature a variable interest rate with a fixed minimum.

A simple and straightforward plan to use U.S. Savings Bonds was passed in the last Congress and will take effect in 1991. This plan is likely to be attractive to parents, not so much from any inherent financial advantages but because it will combine the phrases "tax advantage," "college savings," and "government sponsorship." Unfortunately, the rate or return is modest and unlikely to keep pace with college tuition increases. However, this plan may at least help discourage state plans that pose barriers to interstate attendance.